Managerial Economics &

Business Strategy
Chapter 2
Market Forces: Demand and Supply

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 Overview

I. Market Demand Curve III. Market Equilibrium

The Demand Function IV. Price Restrictions
Determinants of Demand
Consumer Surplus V. Comparative Statics

II. Market Supply Curve

The Supply Function
Supply Shifters
Producer Surplus

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 Market Demand Curve
• Shows the amount of a good that will be purchased at
alternative prices, holding other factors constant.
• Law of Demand
The inverse relationship between price and the quantity
demanded of a good or service is called the Law of
Demand..

Price

D
Quantity
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 Market Demand Curve
• Market demand is the sum of all the
individual demands.
Example: demand for pizza:

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 Determinants of Demand
• Income
Normal good
Inferior good
• Prices of Related Goods
Prices of substitutes
Prices of complements
• Advertising and
consumer tastes
• Population
• Consumer expectations

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 The Demand Function
• A general equation representing the demand curve
Qxd = f(Px , PY , M, H,)

Qxd = quantity demand of good X.

Px = price of good X.
PY = price of a related good Y.
• Substitute good.
• Complement good.
M = income.
• Normal good.
• Inferior good.
H = any other variable affecting demand.

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 Inverse Demand Function

• Price as a function of quantity

demanded.
• Example:
Demand Function
• Qxd = 10 – 2Px
Inverse Demand Function:
• 2Px = 10 – Qxd
• Px = 5 – 0.5Qxd

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 Change in Quantity Demanded
Price
A to B: Increase in quantity demanded

A
10

B
6

D0

4 7 Quantity

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 Change in Demand
Price D0 to D1: Increase in Demand

6
D1

D0

7 13 Quantity

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 Demand Function
The demand for good X is given by
Qxd= 1200- 1/2Px+1/4Py-8Pz+ 1/10M
Research shows that the prices of related goods are given by
Py= $5900 and Pz=$90 while the average income of
individuals consuming this product is M=$55000
a. Indicate whether Y and Z are substitutes or complements
for good X?
b. Is X an inferior or a normal good?
c. How many units of good X will be purchased when
Px=$4910?
d. Determine the demand function and inverse demand
function for good X.

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 Consumer Surplus:

• The value consumers get from a good but

do not have to pay for.

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 Consumer Surplus:
The Discrete Case
Price
Consumer Surplus:
10 The value received but not
8 paid for. Consumer surplus =
(8-2) + (6-2) + (4-2) = $12.
6

2
D
1 2 3 4 5 Quantity

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 Consumer Surplus:
The Continuous Case
Price $

10
Value
Consumer 8 of 4 units = $24
Surplus =
$24 - $8 =
$16
6

4 Expenditure on 4 units =
$2 x 4 = $8

2
D
1 2 3 4 5 Quantity
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 Market Supply Curve
• The supply curve shows the amount of a good
that will be produced at alternative prices.
• Law of Supply
The supply curve is upward sloping.

Price
S0

Quantity

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 Supply Shifters
• Input prices
• Technology or
government regulations
• Number of firms
Entry
Exit
• Substitutes in production
• Taxes
Excise tax
Ad valorem tax
• Producer expectations

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 The Supply Function
• An equation representing the supply curve:
QxS = f(Px , PR ,W, H,)

QxS = quantity supplied of good X.

Px = price of good X.
PR = price of a production substitute.
W = price of inputs (e.g., wages).
H = other variable affecting supply.

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 Inverse Supply Function

• Price as a function of quantity

supplied.
• Example:
Supply Function
• Qxs = 10 + 2Px
Inverse Supply Function:
• 2Px = 10 + Qxs
• Px = 5 + 0.5Qxs

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 Change in Quantity Supplied
Price A to B: Increase in quantity supplied

S0
B
20

A
10

5 10 Quantity
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 Change in Supply
S0 to S1: Increase in supply
Price

S0

S1

5 7 Quantity
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 Producer Surplus
• The amount producers receive in excess of the amount
necessary to induce them to produce the good.
Price

S0
P*

Q* Quantity

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 Supply Function
Suppose the supply function for product is given by
Qxs= -50 + 1/2Px-5Pz
• How much of product X is produced when Px = $500 and
Pz = $30?
• Suppose Pz = $30. Determine the supply function and
inverse supply function for good X.

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 Market Equilibrium
• Balancing supply and
demand
QxS = Qxd
• Steady-state

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 If price is too low…
Price S

7
6

Shortage D
12 - 6 = 6
6 12 Quantity
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 If price is too high…
Surplus
Price 14 - 6 = 8
S
9
8
7

6 8 14 Quantity
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 Price Restrictions
• Price Ceilings
The maximum legal price that can be charged.
Examples:
• Gasoline prices in the 1970s.
• Housing in New York City.
• Proposed restrictions on ATM fees.
• Price Floors
The minimum legal price that can be charged.
Examples:
• Minimum wage.
• Agricultural price supports.

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 Impact of a Price Ceiling
Price S

PF

P*

P Ceiling

Shortage D

Qs Qd Quantity
Q*
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 Full Economic Price

• The dollar amount paid to a firm under a price

ceiling, plus the nonpecuniary price.
PF = Pc + (PF - PC)
• PF = full economic price
• PC = price ceiling
• PF - PC = nonpecuniary price

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 An Example from the 1970s
• Ceiling price of gasoline: $1.
• 3 hours in line to buy 15 gallons of gasoline
Opportunity cost: $5/hr.
Total value of time spent in line: 3 × $5 = $15.
Non-pecuniary price per gallon: $15/15=$1.
• Full economic price of a gallon of gasoline:
$1+$1=2.

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 Impact of a Price Floor
Price Surplus S
PF

P*

Qd Q* QS Quantity
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 Comparative Static Analysis
• How do the equilibrium price and quantity
change when a determinant of supply and/or
demand change?

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 Applications of Demand and
Supply Analysis
• Event: The WSJ reports that the prices of
PC components are expected to fall by 5-8
percent over the next six months.
• Scenario 1: You manage a small firm that
manufactures PCs.
• Scenario 2: You manage a small software
company.

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 Use Comparative Static
Analysis to see the Big Picture!
• Comparative static analysis shows how the
equilibrium price and quantity will change
when a determinant of supply or demand
changes.

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 Scenario 1: Implications for a
Small PC Maker
• Step 1: Look for the “Big Picture.”
• Step 2: Organize an action plan (worry
about details).

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 Big Picture: Impact of decline in
component prices on PC market
Price S
of
PCs S*

P0
P*

Q* Quantity of PC’s
Q0
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 Big Picture Analysis: PC Market
• Equilibrium price of PCs will fall, and
equilibrium quantity of computers sold will
increase.
• Use this to organize an action plan
contracts/suppliers?
inventories?
human resources?
marketing?
do I need quantitative estimates?

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 Scenario 2: Software Maker
• More complicated chain of reasoning to
arrive at the “Big Picture.”
• Step 1: Use analysis like that in Scenario 1
to deduce that lower component prices will
lead to
a lower equilibrium price for computers.
a greater number of computers sold.
• Step 2: How will these changes affect the
“Big Picture” in the software market?

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 Big Picture: Impact of lower PC
prices on the software market
Price S
of Software

P1
P0

D*

Q0 Q1 Quantity of
Software
! "
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 Big Picture Analysis: Software
Market
• Software prices are likely to rise, and more
software will be sold.
• Use this to organize an action plan.

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 Equilibrium
Suppose demand and supply are given by
Qxd =7- 1/2Px and Qxs =1/4Px-1/2
• Determine the equilibrium price and quantity
• Suppose a $6 excise tax is imposed on the good.
Determine the new equilibrium price and quantity
• How much tax revenue does the government earn with $6
tax.
• Find the consumer and producer surplus in equilibrium.
• Determine the quantity demanded, quantity supplied if a
price floor $12 is imposed in this market
• Determine the quantity demanded, quantity supplied if a
price ceiling $8 is imposed in this market

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 Conclusion
• Use supply and demand analysis to
clarify the “big picture” (the general impact of a current
event on equilibrium prices and quantities).
organize an action plan (needed changes in production,
inventories, raw materials, human resources, marketing
plans, etc.).

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 Additional Review
• Baye’s Text, pages 66-71
Question #5, 6, 8, 9, 12, 14, 16, 18, 19
• Chapter 2
Demonstration Problem 2- 3, 4, 5, 6
• Math Review
Graphical Analysis
Area finding. Area of a triangle
Simple Algebra

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